MONEY AND BANKING TIME 1 HOUR

Mona, the manager of the First National Bank, has to make decisions about the appropriate amount of bank capital. Looking at the balance sheet of the bank, which like High Capital Bank has a ratio of bank capital to assets of 10% ($10 million of capital and $100 million of assets), Mona is concerned that the large amount of bank capital is causing the return on equity to be too low. She concludes that the bank has a capital surplus and should increase the equity multiplier to increase the return on equity. To lower the amount of capital relative to assets and raise the equity multiplier, she can do any of three things: (1) She can reduce the amount of bank capital by buying back some of the banks stock. (2) She can reduce the banks capital by paying out higher dividends to its stockholders; thereby reducing the banks retained earnings. (3) She can keep bank capital constant but increase the banks assets by acquiring new funds by issuing CDs and then seeking out loan business or purchasing more securities with these new funds. Because the manager thinks that it would enhance her position with the stockholders, she decides to pursue the second alternative and raise the dividend on the First National Bank stock. Now suppose that the First National Bank is in a situation similar to that of Low Capital Bank and has a ratio of bank capital to assets of 4%. The bank manager now might worry that the bank is short on capital relative to assets because it does not have a sufficient cushion to prevent bank failure. To raise the amount of capital relative to assets, she now has the following three choices: (1) She can raise capital for the bank by having it issue equity (common stock). (2) She can raise capital by reducing the banks dividends to shareholders, thereby increasing retained earnings that it can put into its capital account. (3) She can keep capital at the same level but reduce the banks assets by making fewer loans or by selling off securities and then using the proceeds to reduce its liabilities. Suppose that raising bank capital is not easy to do at the current time because capital markets are tight or because shareholders will protest if their dividends are cut. Then Mona might have to choose the third alternative and decide to shrink the size of the bank. In past years, many banks experienced capital shortfalls and had to restrict asset growth, as Mona might have to do if the First National Bank were short of capital. The important consequences of this for the credit markets are illustrated as follows. The dramatic slowdown in the growth of credit in the wake of the financial crisis starting in 2007 triggered a credit crunch in which credit was hard to get. As a result, the performance of the economy in 2008 and 2009 was very poor. What caused the credit crunch? Our analysis of how a bank manages its capital indicates that the 20082009 credit crunches was caused, at least in part, by the capital crunch, in which shortfalls of bank capital led to slower credit growth. As there was a major boom and bust in the housing market that led to huge losses for banks from their holdings of securities backed by residential mortgages. In addition, banks had to take back onto their balance sheets many of the structured investment vehicles (SIVs) they had sponsored. The losses that reduced bank capital, along with the need for more capital to support the assets coming back onto their balance sheets, led to capital shortfalls: Banks had to either raise new capital or restrict asset growth by cutting back on lending. Banks did raise some capital but with the growing weakness of the economy, raising new capital was extremely difficult, so banks also chose to tighten their lending standards and reduce lending. Both of these helped produce a weak economy in 2008 and 2009. Required: a) Which of the strategies should Mona use to reduce bank capital, and why? b) Which approach should Mona use to raise bank capital, and why should she do so? c) What is a credit crunch, and how did it occur during the financial crisis of 2008 and 2009?